Friday, February 1, 2013

In my estimation, the market continues to underestimate the health of the U.S. economy. To be sure, this recovery still ranks as the worst in modern times. The unemployment rate remains very high. The labor force participation rate remains very low. The number of people working today is still 3 million less than at the peak in early 2008. It's no secret that the economy should be doing a whole lot better. However, the most important thing is what is happening on the margin. The bad news is that the rate of improvement has been disappointing; the good news is that the economy continues to add jobs at a decent pace, and there is no sign of any deterioration. The market is braced for a recession, but there is no sign of a recession; the economy continues to grow, albeit at a disappointingly slow pace.

For the past two years, the private sector has been adding jobs at a 2% pace: about 190K per month on average. That's the same pace as during the 2004-2006 period. According to this chart we are growing just as fast today as we were when the economy was reasonably healthy about 8 years ago. The difference, of course, is that given the depth of the recession we should have been growing much faster.

Both employment surveys show that the private sector of the economy has added a little over 6 million jobs in the past three years. At this pace, jobs will reach a new high within a few years. That will still leave many millions of people unemployed, so it's nothing to cheer. But things are nevertheless improving, not deteriorating. That's critically important, since the markets and the Fed are worrying that the economy is clinging to growth by the skin of its teeth. It's not. It's doing much better than that. Economies are not like airplanes: they don't have a "stall speed." Economies don't collapse if they grow too slowly, they just keep growing slowly.

The January ISM manufacturing report was a good deal stronger than expected (53.1 vs. 50.7). As the above chart suggests, it is reasonable to think that the economy is growing at a 2-3% pace given the health of the manufacturing sector. Things could be a lot better, but they are not getting worse.

As the above chart shows, manufacturing conditions in both the U.S. and the Eurozone are improving on the margin. To be sure, although the survey suggests that Eurozone manufacturing is still shrinking, the pace of deterioration has slowed. On the margin, the outlook is improving both here and in Europe.

Even in Japan the outlook is improving. The Nikkei 225 is up almost 30% since mid-November, thanks to declining deflation risk courtesy of a weaker yen. As the second chart above shows, the January manufacturing surveys in Japan, like in the Eurozone, show a reduction in the rate of deterioration.

It's never smart to let the perfect be the enemy of the good. The economy should be doing better, but it is improving, and that is a far cry from being at risk of recession. Things are likely to continue to improve, albeit slowly.

Markets (and the Fed and most other central banks) are too worried about how things should be better, when they should be encouraged that the outlook is slowly improving.

7 comments:

@Joseph, I agree that the stock market is sanguine -- I'm not sure I agree with Scott that employment is improving -- my guess is that another round of layoffs are imminent -- the sequester cuts are a good start in any case -- the government needs to cut spending by at least 40% immediately -- if I were President, I would issue orders to the military to redeploy all US forces currently stationed overseas back to the US and deactivate those forces -- we also need to decimate Federal employment -- perhaps the best way to do that is with a lottery -- however the government gets there, at least 40% of the spending has to end -- moreover, if greater cuts in government spending are possible beyond 40%, all the better -- if the government cannot figure out how to cut spending by at least 40%, then we should fold up the constitution and start over with something new -- any new government that is formed should have a constitutional standard that forbids government spending and requires all future government employees to serve as volunteers -- everything wrong with America is caused by government spending...

In August 1982 after "two oil shocks", with inflation running at 10% annually and the 30 year Treasury bond having reached 15% the previous year and after a 10 year equity bear market, the Dow Jones Industrial average hit bottom at 660 on the 12th. The mantra had been that hard assets like oil, gold and silver, farm land, timber, etc could "only go higher".

As stocks - to everyone's amazement - rapidly rose in price, an editor at Barron's interviewed someone for his Saturday column and asked him for a contrary opinion. He said: "Things will work out just fine." It was hard to believe given what we had been through the previous decade.

Regarding the stock market, we may want to consider that stocks are not increasing in value per se, but rather, the dollar is losing value -- the rise in stocks seems to be concomitant with a declines in the value of the dollar worldwide -- my hypothesis is that increased valuations in stocks is only keeping up with declines in the dollar -- the only equities not losing value today are stocks and world-class skills -- anyone reliant upon either government incomes and/or pensions is basically ruined once the real inflation becomes evident later during the 21st century...

EWJ (iShares MSCI Japan) is exactly where is was in March 2012. You cite local currency performance. Ask investors in Zimbabwe stocks how rich they feel."No sign of recession". Is that whistling in the dark? You do not mention the -0.1% GDP print with one single word. Things getting better at the margin? GDP doesn't think so.

Dr. K wants 40% spending to be cut, but still recommends leveraged equity investments? You saw what $20bn in missing defense spending did to GDP. You definitely DON'T want to be invested when they cut 40% of spending.